Value of Perfect Information

This time of year you will here a lot of people talking about faith.

In the currency markets it is all about “full faith and credit”, in the central bank, in the government backstopping.  In the case of the European central bank it is the full faith in the principle backstopping.  The commitment to a sound currency.  This is the rationale behind the exodus into Europe.  That, no matter how many PIGS the Germans try to throw on the tracks, the ECB rate hike machine will plow ahead.

A massive short dollar trade came out of Asia on 4/20 -see “breakaway gap?” lower in UUP (below):  This ignited the ‘Carry Trade’ into hard assets worldwide.  Most commentators missed the point of the rally completely and no one challenged them.  QUESTION:  Why would oil rise $3.00 back to our top target of $112/$114 when the conflict in Libya is winding down – When Saudi Arabia says no demand in sight for additional oil – when IEA officials promise more oil on the way by June   .   BECAUSE OIL IS PRICED IN DOLLARS!

Faith!

As I alluded to in ‘Sympathy for the Dollar’ traders have faith that the US central bank, Treasury, powers that be, have opted for hyper-stagflation vs. deflationary recession as they drive the dollar lower, punishing international bondholders.  This could get ugly!

I have faith also.  Faith in human nature.  Faith in traders resolve.  With the Dollar Index approaching all-time lows last seen just over eleven hundred days ago, I have faith that traders will challenge that mark (closing low of 71.67 set on 3/24/08) before the sun sets many more times.  Then Mr. Geithner will face his own Waterloo moment.  Will he let the dollar go quietly into that goodnight?  Is Dollar Index @ 65 the ‘New normal’?  Someone find out which side of the trade Mr. Soros is on, he’s been too quite lately.

One of my favorite quotes from one of my favorite actors:  “I can’t see it yet but It’s coming very close now!” Max von Sydow -Dune.

The March Empire Manufacturing Survey showed an improvement in March over February.  The general business conditions index inched up 2 points, to 17.5. The new orders and shipments indexes fell but remained above zero, while the unfilled orders index rose above zero for the first time in a year.  This is not a major market moving survey but there are a few points were noting, primarily future expectations on inflation and capital expenditures.  There has been a trend within all regional manufacturing surveys with rising input costs.  This report is no different.

Prices paid and prices received – 6 month forward expectation

From February to March those reporting higher prices paid increased from 57.8 to 72.7 while those reporting higher prices received increased from 33.7 to 38.9.  The margin compression story grows.  Manufacturers are very limited in their ability to pass along higher prices.  Corporate margins appear to be peaking which will put pressure on equity prices.

Capital Expenditures – 6 month forward expectation

From February to March those reporting higher capital expenditures increased from 33.7 to 35.0 while those reporting lower capital expenditures increased from 6.0 to 13.0.  If business was so confident in the economy why are they pulling back capital expenditures?  Not a positive sign of future economic growth.

Cost of Capital

From October 2010 to March 2011 those reporting higher cost of capital increased from 10.0 to 31.6 while those reporting lower cost of capital decreased from 11.7 to 2.6.  So much for the Fed and QE lowering borrowing costs to help expand the economy.  Further proof of shrinking bank balance sheets and an aversion to risk.

The Philly Fed Survey reported on Thursday blew away the estimate of 22 with a reading of 35.9. Although the headline number was positive a worrying sign is the drop in new orders which does not bode well for future surveys. I came across the following survey within the report though and wanted to highlight an interesting trend.

The first part of the survey (section a) asks who has raised prices on finished good. 56.5% report a price increase from 0-10%. Looking at the second part (section b) the trend continues with 59.2% expecting to further raise prices over the next three months.

Bernanke tells us that price increases are due purely to supply and demand but his argument is not supported by the third part of this survey. When asked “are you currently experiencing shortages or delayed delivery of any critical raw or intermediate products” 67.1% reported NO. Input costs continue to rise very quickly, yet supply is keeping up with demand. This would imply costs are being driven more by speculation than a strengthening global economy.

GDP missed with a 3.2% read versus the estimates of 3.5%.  Looking purely at the highlights, two things stood out.  First, the drawdown in inventory for the first time in five quarters.  Inventory was a net drag on GDP by 3.70%.  The second and probably more eye catching stat was the Final Sales figure which showed a solid rise to 6.87% from a prior read of .94%.  So at the headline level although a miss, the report showed some positives.

Like anything though you need to read behind the headline to find the true story.  Without making GDP to confusing, let’s break it down to the simple formula

GDP = Consumer (C) + Investment (I) + Government (G) + Trade Balance (T)

The chart below shows how each component of GDP have changed over the past eight quarters.   The two areas that standout are the changes in (I) investment and (T) trade.  We did notice (G) government begin to turn down and become a net drag on GDP and we also saw (C) consumer tick up adding more to GDP growth.  For the most part though (I) & (T) were the largest fluctuations.

The Trade component was a little confusing as it showed an increase in exports which makes sense considering the dollar debasement, but a substantial decrease in import growth by 2.40%.   The drawdown in inventories would be offset partially by the drawdown in imports but the amount was larger than would be expected considering the fact that the consumer showed strength this holiday.  GDP is quoted in real terms (inflation adjusted) from nominal values.  The BEA uses different price deflators in this adjustment and the deflator for imports is much larger than that of GDP as a whole (.3% for GDP and 21.8% for imports).  So part of this trade benefit to GDP was purely using an uneven price deflator that favored GDP versus imports.

The Investment component which is where inventory resides, showed the first drawdown in inventory levels in five quarters.  Odds are this is not a blip but rather a trend where inventory will continue to be a drag on GDP. Until real demand comes back into the economy the desire to build GDP to higher levels will not be there.   So as inventory levels stagnate or reduce further based on sales, the (I) investment component of GDP should put more downward pressure on GDP.

The table below shows the past eight quarters and a breakdown of GDP by various components.

Another way of calculating GDP is using final sales and changes in inventory.

GDP = Final Sales + Changes in Inventory

In other words, Final Sales = GDP – Changes in Inventory.  As a result the big drawdown in inventory resulted in a big rise in final sales.   The graph below shows final sales over the past eight quarters.  Seems rather hard to have full faith in this GDP calculation method with final sales going up in one quarter from .94% to 6.87% (that’s quite a trajectory).  Graph of final sales over the past eight quarters is below.

So on the surface GDP was a miss but looked OK.  Behind the headlines though questions do arise.  It’s also important to note that this is the first of three more revisions to GDP.  For most of the report there are only two months of data (October and November) with December being more of an estimate.

There is a lot of talk in the financial media about the strength of the consumer.  Pundits will tell us to never count the consumer out.  The holiday season was strong, iPad sales are strong, the high end consumer is spending. In a word, nonsense.

The number of people in some form of default on their mortgage continues to rise.  The average time from the first missed payment to REO is in excess of fourteen months and higher depending on who is reporting. Imagine not making a mortgage payment for fourteen months.  What do you do with that money?  You don’t save it all. You spend it on things you are “entitled” to because the sad truth right now is our society for the most part feels entitled.

Consumers guard their credit card and HELOCs because it is their only form of credit and yet the banks spin this as a positive about their assets, their credit quality.  Again, I say nonsense.  I came across two charts that really support this view.

For the first time in over sixty years, Americans had a net withdrawal of financial assets, whether it be savings, 401K plans, etc.  Americans are suffering hard right now.  One in five are employed part time.  Part time work is necessary and there is nothing wrong with that form of employment but the reality is you cannot grow an economy with limited wages and reduced benefits.

Now this one was the scary report from FINRA.  The simple question, how many Americans have available funds to cover three months of normal expenses.  35.3% do while 60.4% do not.  GOD forbid someone loses a job, for every three that lose work today, two need immediate government aid.  One in seven Americans are on food stamps.  There are many people hurting right now and for the media and financial system to spin it as all is well is very sad.

All of us seek to determine a “fair value” for whatever investment we typically trade. Although I have studied the S&P 500 at length for many years, I could not find a good “fair value” estimate for the aggregate index. Sure, there are models out there, and one happens to be created by Professor Robert Shiller. He divides a monthly S&P average by 10 years worth of earnings and adjusts for inflation. This has become the Cyclically Adjusted Price to Earnings Ratio (CAPE) model. Prof. Shiller uses S&P earnings and BLS CPI data as inputs to his model. The underlying data is easily found on the internet. The picture below is his popular chart.

I downloaded his data to compare CPI adjustment vs Nominal and here is the result.  I sort of question the rationale in adjusting for CPI.

Additionally, I questioned his method of using 10 years vs longer timeframes.   I tried to improve Shiller’s data, as just having a number such as 21.17 trailing P/E without a corresponding index price in the chart seemed lazy.  Here is Shiller’s data compared to the S&P over the same time period.

Finally, I decided to track both nominal and CAPE for 5, 10, 20, and 30 year timeframes to give someone the option of which time they choose is most important, shown below:

I also included a Combined Fair Market Value that adds differing times and several other indicators together, shown here.

The entire report is located here for your pleasure.

http://www.scribd.com/doc/42399987/CFMV-Q3-10

By Robert McHugh, Ph.D.

November 6th, 2010

Let’s look at some of the Fundamentals of the economy which eventually leak into the market at some future equilibrium price in the future:

The Bureau of Labor Statistics, a division of the Labor Department, announced Friday, November 5th the results of their employment survey and statistics for the month of October 2010. Using just their numbers, they reported that non-farm payrolls rose 151,000 in October. However, they goosed this figure by 61,000 make believe, guestimated, assumed, non-counted fictitious jobs they presume were created by new businesses they think started up, net of businesses that closed down. That brings the non-farm payroll figure down to 90,000. But, of that 90,000 reported new jobs, 35,000 were in temporary service jobs. So, if we take that figure out, we are down to 55,000 new jobs created in October. However, the U.S. needs to create 150,000 new jobs every month just to accommodate population growth, which means that once again, job creation fell short by 95,000 in October. In other words, the employment picture got worse.

The BLS reported that the unemployment rate, by their convoluted calculations, remained at 9.6 percent, 14.8 million good folks out of work. However, they purposely chose to not count 2.6 million unemployed folks who wanted work, looked for full time work within the past 12 months, but did not look during the most recent 4 weeks for one reason or another. For 1.2 million of those 2.6 million, the reason was they were so discouraged, they figured, “why bother.” The BLS 9.6 percent figure would have risen to 11.28 percent by including those 2.6 million, no arguing the truth there. That is really the number that should be reported. But worse, the BLS does not count the underemployment rate. There were 9.2 million folks who wanted to work full time, but were denied that opportunity involuntarily, by having their full time hours cut back, or by settling for a part-time job while they continue their search for full time work. If we add those good folks to the unemployment ranks, we find that the underemployment rate was 17.2 percent. That means more than one out of every six employable people were either unemployed or stuck in a part-time job when they wanted full time work.

Then there is the immeasurable group of folks who have full-time work, but in a job that is below their skill level, and at a pay rate below what they had in previous full-time work. Add to them those who have full time work on salary (do not qualify for hourly overtime pay), but work more hours now than they did before to cover the responsibilities of fellow workers who got laid off, but also did not get a salary increase. Not sure how many of these good folks are out there, burning out, giving up quality of life just to keep their jobs. Then there are those who have full time work, but have not been given raises because their employers suggested they be happy at their current wage or else they will be replaced by someone else willing to work the same job for less. Call this entire paragraph the “quality of work” work decline, which I do not believe anyone has a handle on. But if you talk with friends and neighbors, empirically there are a ton of folks in this category, a category whose numbers have increased dramatically since the Bear Market started.

All this adds up to an employment picture that is grim, and getting worse. The impact of course is on consumer spending, which accounts for 70 percent of GDP. The only solution out of this mess is a massive income tax rebate and tax cut, placing the QE2 Dollars the Fed is printing, into the hands of households, and not Wall Street where QE2 is going. If households got the money, they would lower their debts, and increase their spending. That increase in spending would boost small business revenues. Small businesses (who are responsible for 70 percent of hiring) would then start hiring to handle the increase in sales. Small businesses would then spend more, boosting sales of large corporations. Large corporations would then add jobs and go to Wall Street for capital. Wall Street’s profits would grow from investment banking operations, rather than the Trading accounts QE2 are designed to goose. At every level, government tax revenues would get a piece of the action. Voila, prosperity for all!

If I were king, this is what I would do. I would cancel QE2, as that will have no positive impact on the economy or employment. I would then do QE3, a one time only event. It would be designed to choke start a dead economy and deteriorating employment picture that will eventually lead to a Great Depression.  

I would have the U.S. Treasury issue at least $5.0 trillion of new Treasury note securities, short to intermediate term, up to 5 years in maturity. This term is chosen because this economic “trickle up” plan would reap returns to the Treasury in the form of massive tax revenues by year five without the necessity to raise income tax rates, rather while actually lowering income tax rates, when this debt could be retired. I would then sell these $5.0 trillion of securities in the open market, with the Federal Reserve as buyer of last resort, providing demand if necessary. Even if the Fed buys all of these securities, it is okay because the Treasury will be retiring them within five years anyway from the increase in tax revenues it will accrue from a growing and prospering economy.

Then I would take that $5.0 trillion and rebate 1 to 2 years of income taxes to households (not businesses), with a minimum rebate of $25,000 since many folks were unemployed and do not have income over the past two years. Small businesses would end up getting the rebate because there are many who file subchapter S returns that flow to household tax returns. I would then require that half the rebate be used to pay down debt. This would result in stronger financial balance sheets for households and lending institutions. Banks getting their loans repaid would see their non-performing assets decline, and see their loan portfolios decline. That would improve their capital ratios and their liquidity. In conjunction with improved household financial positions, this would put banks in the mood to be accommodative in lending practices, which would help the economy. This would strengthen the FDIC’s reserve position as fewer banks would fail.

Households would then take the rest of the money, and feel more confident about the future, and likely spend on items they have been holding back on due to necessary austerity. This would boost small business sales, which would result in job creation to accommodate the increase in sales. This would increase small business’ demand for the products and services of large corporations. Large corporations would then turn to Wall Street firms for capital and loans, boosting Wall Street’s profits, not from Trading schemes courtesy of the Fed, but from growth in aggregate demand, the economy. Local, State and Federal government entities would get a piece of the action at each level, increasing their tax revenues, allowing them to retire debt and increase infrastructure spending which would create more jobs.

This results is prosperity for all, a growing pie, growing aggregate demand. With the increase in tax revenues, the Treasury then retires the $5.0 trillion of newly issued debt that kick-started this economic recovery plan. The Fed sells its securities back to the Treasury, and the U.S. Dollar retains its value.

This will not happen, because both political parties seem intent on solving economic problems with a top-down approach, where they give trillions of Dollars printed out of thin air to Wall Street who then take the money and earn increased Trading Account profits with mega-purchases and profit-taking sales of stocks and other financial instruments, like some wealthy drunk at the casinos. A great deal of this money will get destroyed, disintegrate at a coming stock market plunge, and the wealthy Wall Street Trading machine will end up leaving the gambling table broke once again, with all the money from the Fed gone for good, leaving a trail of a devalued Dollar, rising unemployment, falling home prices, failing banks and businesses, bankrupt families – the  next Great Depression. That will lead the Central Planner’s to the bright idea where sovereign nations merge into a new Union of Western States, including North America and Europe, in an attempt at one world government they falsely hope will fix the mess they created. Unfortunately this is probably the path we are on.

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“Jesus said to them, “I am the bread of life; he who comes to Me

shall not hunger, and he who believes in Me shall never thirst.

For I have come down from heaven,

For this is the will of My Father, that everyone who beholds

the Son and believes in Him, may have eternal life;

and I Myself will raise him up on the last day.”

John 6: 35, 38, 40

On the surface, sure, all looks well. To even talk about a double dip right now will get you banned from CNBC (which isn’t a bad thing for your credibility). Before people go ahead and call mortgage gate a non issue, bank health a non issue, macro economics as rebounding, check out the headline from October 5, 2007 (yes 2007).

Nonfarm payrolls rose by 110,000 last month — including 73,000 in the private sector — very close to expectations of a 113,000 gain in total payrolls.

The S&P 500 highs were on October 8, 2007. What happened after that? Subprime was NOT contained. Financials having declined for 5 months were a leading indicator of the indices. The economy was not doing a goldilocks dance as Kudlow so proudly declared each night. This is all in the back drop of a weakening dollar and rising commodity prices.  Seems quite familiar to our current environment.

Bulls are celebrating ISM Manufacturing and Services reports showing expanded growth (above 50 is expansion, below contraction). Looking inside the report shows some troubling signs though, primarily prices paid. As the USD has continued to get slammed the past few months, input costs have continued to rise. In this current economy, producers do not have pricing power on non essentials to pass along those higher prices. The result is their margins have been and will continue to get squeezed. To combat tighter margins, employers will begin laying off “non-essential” employees. New Orders in both reports have shown increased strength which is certainly a good sign for future ISM reads but is this solely due to the weak USD helping exports? Just like the EUR/USD was going to parity back in the summer, everyone is talking the end of the USD right now as the reserve currency. At some point that may very well be true but a reversal in the USD will put pressure on future ISM reads. Sovereign debt concerns have not passed, just kicked a little further down the road. Dec. 7 is national run on the bank day in France, which has now spread to a handful of other countries all as a result of austerity and another form of protest (important to remember EU banks are leveraged 10 times US banks). Don’t be so quick to favor the EUR over the USD. Both currencies are bad but it’s a lesser of two evils scenario right now.

So the ISM manufacturing and services both were positive signs for future growth of the US economy but need to be taken in context of what is driving them.

Monday, October 25, 2010

Alert …. Bullard to speak at 1:30 p.m. today….So is QE II going to happen!

Doves pretty much have the votes

Bullard on the fence…

Fed’s Bullard: Want to See GDP, Other Data Before Back QE2

St. Louis Federal Reserve Bank President James Bullard said Thursday that he wants to see more data before deciding whether or not to support a resumption of quantitative easing at the Fed’s early November monetary policy meeting, but said that if the Federal Open Market Committee does approve “QE2″ he would like to see it announce $100 billion in long-term Treasury security purchases between FOMC meetings.

Bullard, a voting member of the FOMC, said that the FOMC should then proceed meeting by meeting in a “disciplined” and “flexible” way to assess whether and how much further asset purchases are needed. And he said the Fed should not set itself a purchase limit but rather should leave the amount “open-ended.”

Bullard, talking to reporters on the sidelines of a St. Louis Fed conference, said the FOMC could provide “forward guidance” on whether or not further quantitative easing was likely to be necessary based on its latest assessments of the forecast for economic growth and inflation.

He likened his suggested approach to the way the FOMC conducts conventional policy, in which it moves the federal funds rate up or down in increments of 25 basis points and doesn’t pre-announce how far the it will take rates in any direction.

Bullard said he believes quantitative easing would be effective in lowering interest rates and said that, indeed, the mere anticipation of QE2 has been effective in lowering long-term interest rates.

However, he said QE2 is still “a tough call” in his mind.

Looking forward to the Nov. 2-3 FOMC meeting, Bullard called it “an important one” in which he and his colleagues must go through the “important exercise” of revising their quarterly, three-year forecast.

“A key part of that updating is the outlook for 2011,” he said. “So we will have to assess that.”

He said he has not yet made his own forecast, saying he wants to “wait for the last minute to get the most data I possibly can.”

“One key report that has yet to come in is the third quarter GDP report,” he noted, adding that “it may come in a little stronger than the second quarter.” So he said “we have to keep our eye on that.”

Bullard said he will “wait until all the data comes in” before deciding whether QE2 is needed.

“No decisions have been made, and no decision will be made until the November meeting and we have a chance to hash it out there,” he said.

“If we do decide to go ahead with quantitative easing,” Bullard outlined “a good program we could adopt.”

He said the FOMC “could think in terms of units of $100 billion (of purchases) between meetings” and “think about the level of the balance sheet as being the operative part of this policy, so if you decide to purchase $100 billion more what you’re saying is you’re going to increase the size of the balance sheet by $100 billion … all in longer date Treasuries.”

Bullard said the FOMC “could give forward guidance” on “how likely it is that we continue these purchases in the next meeting.”

“By extension that would set up a whole path of purchases for the future.”

Asked whether the FOMC should set a maximum amount of intended purchases, as some officials have implied, Bullard replied, “I think for now you’d just leave it open ended. I think that would work just fine.”

Again likening it to funds rate policy, Bullard observed, “when we do interest rates … (and) you embark on an interest rate tightening and you go up 25 basis points you don’t name an end point.”

Fed watchers “could extrapolate and say they’re going to go all the way to 20%,” he said, but in practice that’s not what happens.

Kansas City Fed President Thomas Hoenig, a fellow FOMC voter, has warned that once it embarks on QE2, the FOMC could find itself buying more and more securities and pumping more and more excess reserves into the banking system in order to achieve an effect — leaving itself with a much larger balance sheet from which to eventually exit.